Monday, September 23, 2013

What the JOBS Act means for startup funding: beware the cookie lickers

Seed money. Angel investing. Venture capital. Funding start-ups that aspire to be "big business" has become a strange beast. Today is the official effective date for Title II of the JOBS Act, which many are hopeful can kick off a New Great Era of fundraising. But in many ways, this is a huge red herring.

Once upon a time pretty much any company that wanted to could raise money according to a broad array of "blue sky" laws which varied by state:

Blue sky laws developed in the frenzied years leading up to the Great Depression, in response to fact that more and more ordinary investors were losing money in highly speculative or fraudulent schemes promising high investment returns, such as oil fields and exotic investments in foreign countries.

But after the hype, boom, bust and onset of the Great Depression, thinking changed a bit. The passing of the Securities Act of 1933 was done with the belief that selling such "risky" early-stage investments to the general public left too much room for swindling. You know -- bad guys running off with Grandpa's life savings (Which never happens today. Right, Bernie Madoff?). Accredited investors are the only ones who can 'afford' to lose, so let's make rules that allow only them take risk that yields high reward -- apparently this was the logic behind Rule 501 of Section D of the Securities Act of 1933, a rule which states that entities need a certain "net worth" to participate in investments which potentially might go public.

But of course, by shielding "small time" potential investors from swindlers, so too were those small- time investors denied opportunities to reap rewards earned from their decision to take risk. As a result, the next 80 years or so saw an entire profiteering industry sprout up around capital finance, start-ups and highbrow private investing -- an industry "for the elite, by the elite" -- hedged on early access and exclusive access, it is essentially wealth funneling wealth. It perpetuates by protecting first (usually via preferred stock) the wealth of the wealthiest "if and only if; then and only when" a tiny bit might "trickle" down to common shareholders -- including founders themselves!

If you think this logic sounds a little hokey, you're not alone. Several arguments for scrapping the "accredited investor" rules have floated around, but during the last 80 years, exactly zero headway has been made. Fred Wilson commented in a May, 2012 Forbesarticle:

The biggest issue: there is simply too much money. Although $30 billion continues to flow unabated into venture-backed companies annually in the U.S., venture capital as an asset class hasn’t outperformed the market since the early 90’s, when only $10 billion was put to work.

What's happening? In plain English what's happening is this -- that "exclusive access" members' only club is getting fat, tired and cranky. Despite the fact that it already has too much on its plate and not enough time to chew, its people just won't stop licking cookies. Many of those licked cookies are going to waste.

Enter the JOBS Act to "Jumpstart our Business Startups", a plan to help those little guys with freshly baked cookies -- what can be done to change things and help them get their cookie empires off the ground? Should we make it easier for these guys to advertise their cookies? Yes! But first we should probably get rid of the law that makes it illegal to advertise cookies.

September 23 is the official effective date for Title II of the JOBS Act, which many are hopeful can kick off a New Great Era of fundraising. But in many ways it's a huge red herring: all it permits is the mere existence ofinformation. Start-ups now may "legally" use the Internet and/or public airwaves to inform the public that they're looking for capital to grow their business! Then, with whatever attention their hype is able to attract, those start-ups may be asked to get in line to have their cookies licked by an authorized VC cookie licker.

Of course, the trends threatening VC’s bode well for entrepreneurs. More competition among investors means easier financing and better terms for startups. The eye-popping valuations of some companies may already be a reflection of this phenomenon. Wilson admits that this glut of funding is also probably good news for the economy, job creation and the proliferation of new goods and services.

But whoa. . . big caveat here -- if a cookie seller accidentally let their cookies get licked by somebody who isn't "legally" allowed to lick cookies, they may get in #BigLegalTrouble and have to wait an entire year to get in the back of the line again. Seriously.

The spin on this from the VC side seems to be that there 'ought' to be more competition among VC's ... but is that the issue? Last time we checked, competition among VCs wasn't the problem; as Paul Graham stated in his recent essay, it's competition for that "first" bit of VC attention that every entrepreneur needs to get the ball rolling:

The biggest factor in most investors' opinions of you is the opinion of other investors. Once you start getting investors to commit, it becomes increasingly easy to get more to. But the other side of this coin is that it's often hard to get the first commitment.

Obviously, we need a larger pool of potential investors / cookie-lickers to woo. How, exactly can this happen?

The problems that existed at the time of the Securities Act of 1933 -- and the subsequent red tape and paperwork formalities to protect Grandpa's life savings -- surely these were well-intentioned protections. But the reality of the world today is such that there are too many cookies going to waste. The professional cookie-lickers of the world just don't have time to sample all the great cookies today's entrepreneurs are making. Gambling halls and casinos (which certainly are just as likely to swindle Grandpa's life savings) don't require minimum net worth or income limits for patrons, so why are they imposed on investors, where the potential for Return on Investment (ROI) is significantly more feasible?

Title II doesn't address the core problem, but hopefully it can attract more attention and scrutiny to the issues preventing many small and medium-sized businesses from taking root. Namely -- "accredited investor" rules are antiquated and unnecessary, and they do more harm than good for many small and medium-sized businesses that just want to sell cookies.